The marginal cost of public funds and the flypaper effect

A lump-sum intergovernmental transfer has a “price effect”, as well as an “income effect”, because it allows the recipient government to reduce its tax rate, which lowers its marginal cost of public funds, while still providing the same level of public service. This reduction in the effective price of providing the public service helps to explain the “flypaper effect”—the empirical observation that a lump-sum grant has a much larger effect on spending than an increase in personal income. Contrary to the assertions of Mieszkowski (Modern Public Finance, 1994) and Hines and Thaler (J. Econ. Perspect. 9:217–226, 1995), a model of a benevolent local government financing its expenditures with a distortionary tax predicts flypaper effects from lump-sum grants that are similar to those observed in many econometric studies.